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Greetings Tutor, I Hope, you are doing well. First and foremost, I want to offer a sincere apology for not being able to respond to the answers that you provided.
I was trying to understand the logic behind the Doctrine of Capital Maintenance.
Taking a hypothetical example of a Company called XYZ Corp. XYZ Corp has a share capital of $1,000,000 and total assets worth $2,000,000. The company also has liabilities of $500,000.
In this case, the net assets of XYZ Corp would be calculated as follows:
Net Assets = Total Assets – Liabilities Net Assets = $2,000,000 – $500,000
Net Assets = $1,500,000.Since the net assets of XYZ Corp ($1,500,000) are greater than its share capital ($1,000,000), the company is maintaining a sufficient level of capital. This means that XYZ Corp has enough net assets to cover its debts and obligations to creditors. By maintaining this adequate level of capital, XYZ Corp can meet its financial obligations and reduce the risk of default or insolvency.
What is wanted to ask here is, the fact that the Net Asset are 1500k, shows that the Company has enough Assets to cover is debts (liability) and even after that (i.e. settling the debts) it would be left with an Asset worth of 1500k. Thus providing the Creditors a layer and sense of security that their lending is quite safe.
Looking towards an early reply.
The mere expression ‘net ASSETS’ tells us that there are (in theory, at least) sufficient assets to satisfy creditors’ claims.
Problems arise when liabilities exceed assets and we have a ‘net liabilities’ situation
You say that you are looking forward to an early reply. A reply is, by definition, a response to a question. And yet I see no question in your post ???
Do you have a question now or is my observation sufficient to resolve your doubts?
Thankyou Tutor, based upon your last response does this means that Capital Maintenance is more a theoretical concept than having more practical relevance?
In regards to example of XYZ Corp. What i want to ask is that Net Asset (Asset – Liability) is $1500,000.
What does the figure $1500,000 signify to the creditor ? How by this figure they feel that their debt is secured?Is it because that the Amount of $1500,000 theoretically shows that even if the company were to incur losses up to $1,500,000, there would still be sufficient assets to cover the claims of Creditors?
In a different sense can we say that if the company were to liquidate its assets at their stated values in the Statement of Financial Position (SOFP), there would still be an excess of $1,500,000 after paying off the debts.
Thus, the excess serves as a cushion for creditors, giving them confidence that their debts are safe .
Consider this statement of financial position:
Share capital 1,000
Share premium 100
Retained earnings 1,200Total shareholders’ funds 2,300
Assets 2,800
Liabilities 500Net assets 2.300
(As per John’s lectures in the early accounting paper, shareholders’ funds = net assets)
Our company wishes to pay a dividend out of profits available for the purpose. In our case, that’s 1,200 (accumulated realised profits less accumulated realised losses)
Dividend of 300
Statement of financial position is now:
Share capital 1,000
Share premium 100
Retained earnings 900Shareholders’ funds 2,000
Assets 2,500
Liabilities 500Net assets 2,000
Even if our company were to make a loss next year, say 700, the statement would then read:
Share capital 1,000
Share premium 100
Retained earnings 200Shareholders’ funds 1,300
Assets 1,800
Liabilities 500Net assets 1,300
Let’s convert the share premium into shares
Share capital 1,100
Share premium nil
Retained earnings 200Shareholders’ funds 1,300
Assets 1,800
Liabilities 500Net assets 1,300
Still ample coverage of the 500 payables. In fact, that share capital figure (together with any undistributable reserves like the share premium account) is collectively referred to as the ‘creditors’ buffer fund’. It’s the amount below which the net assets cannot fall … IN THEORY
Next year, we sustain a loss. 900!
Revised statement is now:
Share capital 1,100
Retained earnings (700)Shareholders’ funds 400
Assets 900
Liabilities 500Net assets 400
Can we now pay a dividend? No, not without breaking the capital maintenance rules. Say we wanted to pay a dividend of 600 to our troubled shareholders (we can’t! But pretend we can)
Share capital 1,100
Retained earnings (1,300)Shareholders’ funds (200)
Assets 300
Liabilities 500Net liabilities (200)
Now what chance do our payables have of getting their balance repaid?
But notice that the share capital figure still stands at 1,100! This was the major element of the creditors’ buffer fund. And yet the payables now have no chance to recover their balance.
So the concept of capital maintenance is all well and good … but you cannot legislate against companies making losses!
Instead of a dividend in that last illustration, say our company makes another devastating loss. Say 600
Now we have:
Share capital 1,100
Retained earnings (1,300)Shareholders’ funds (200)
Assets 300
Liabilities 500
Net liabilities (200)Your posts appear to me to be comparing the payables figure with the share capital amount. That would not be a sensible approach
OK?
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